Tài liệu Determinants of currency crises in emerging economies in 1996-2005 an early warning system approach

UNIVERSITY OF ECONOMICS HO CHI MINH CITY VIETNAM INSTITUTE OF SOCIAL STUDIES THE HAGUE THE NETHERLANDS VIETNAM- NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS Determinants of currency crises in emerging economies in 1996-2005: An Early Warning System approach A thesis submitted in partial fulfillment of the requirements for the degree of Master of Arts in Development Economics By' , Trtrang Hong Tuan . • BQ GIAO DVC FJAO TAO TRUONG fJ~f HQC KINH TE TP.HCM Thesis supervisor: Dr. Vii Thanh Ttr• Anh Ho Chi Minh city, October 2009 THliVIEN • ~1 r- Certification I declare that the thesis hereby submitted for the Master degree at the Vietnam-Netherlands Programme for M.A in Development Economics is my own work and has not been previously submitted by me at another university for any degree. I cede copyright of the thesis in favor of the Vietnam- Netherlands project for M.A programme in Development Economics. Ho Chi Minh City, October 2009 Truong H6ng TuAn. Page 2 of 52 Abstract Theories of currency crisis consisted of 4 generations of models suggest that economic and institutional variables can be employed in early warning system models to predict currency crisis for the purpose of prevention policy. This study incorporates 5 variables from Berg and Pattillo (1999b) model (Real exchange rate overvaluation, Foreign reserves loss, Export growth, Current account deficit, Short-term external debt/Foreign reserves) and additional Domestic credit growth, 6 institutional variables adopted from Worldwide Governance Indicators (Kaumann et al., 2008) (Voice and Accountability, Political Stability and Absence of Violence, Government Effectiveness, Regulatory Quality, Rule of Law, Control of Corruption) into a simple logit model with dataset of 15 emerging market economies in the period 1996:01-2005:09. The new finding is the high statistical significance of the variable 'Voice and Accountability' (represents freedom of speech, free media and ability to participate in selecting government of a country citizen) on reducing probability of currency crisis. 'Regulatory Quality' (measures government ability to implement efficient policies promoting private sector development) also shows its statistical significance at a lower level in the model. This study also reconfirms other studies that Domestic credit growth and Current account deficit precede currency crisis. Page 3 of 52 TABLE OF CONTENTS Certification 2 Abstract 3 Table of Contents 4 Chapter 1 Introduction 5 Chapter 2 Theories of currency crises - A brief review of the literature 7 Chapter 3 Typical early warning systems and empirical currency crisis models A brief review of the literature 18 Chapter 4 Methodological issues - Empirical framework 27 Chapter 5 Empirical results 36 Chapter 6 Policy implications and conclusion 40 Notes 42 References 42 Appendix 1 Specification of 05 empirical currency crisis models 45 , Appendix 2 Logit regression results by Eviews (Probability of currency crisis) 47 Appendix 3 Robustness test of the result by running logit regression on regions 50 Page 4 of 52 Chapter 1 Introduction 1.1 Statement of the Problem On the way to development, currency crises are very costly for emerging economies. Currency crises can lead to banking crises, loss of GDP, high unemployment rate and loss of development momentum. In the Asian crisis in 1997-98, Thailand lost 10.5% of GDP, Indonesia 13.1% & Malaysia 7.4%. In May 2008, Morgan Stanley issued a report on Vietnam named "Beyond the tipping point", comparing Vietnam then with Thailand in 1997 and warning a 38% -55% depreciation of VND against USD in the next 12 months. In June 2008, State bank of Vietnam widened trading band for foreign exchange (USD) from 1% to 2%. In November 2008, it raised the band to 3% and in March 2009 to 5%. Domestic credit growth rate is 50% in 2007, 34% in 2008 and estimated 30% in 2009 by Economist Intelligence Unit. After the booming in stock and real estate market in 2007 with capital inflow mainly for portfolio investment, a crash of more than 70% in stock market broke out in 2008 against its peak in October 2007. Capital inflow and export shrink, larger current account deficit (13.6% in 2008) is putting pressure on the peg regime of VND to USD. It seems that the scenario of Asian crisis repeats in Vietnam. Unlike Asian crisis countries of crony capitalism, Vietnam's relationship-based system has even weaker institutions. So do institutions play any role in setting stage for a currency crisis? Now is October 2009. Fortunately, the Morgan Stanley's forecast failed, but whether the Vietnam currency crisis is coming soon? Thus, currency crisis is a burning issue in Vietnam for the time being. 1.2 Objective of the Research Page 5 of 52 Vietnam is an emerging market economy. Understanding what caused currency crises in other emerging market economies in recent years would be a good reference for further comprehensive researches on what Vietnam should do to prevent its own currency crisis. 1.3 Research Questions This study aims to answer the following questions: 1. What are the key determinants of currency crises in emerging economies in the period 1996-2005 in the light of early warning system approach? (especially, current account deficit, domestic credit growth and institutional factors) 2. What are the policy implications to prevent a currency crisis? 1.4 Research Methodology Based on theories, empirical models of currency crises and available variables/data, regression with logit model is carried out to recognize the determinants of currency crisis. The statistic software Eview 4.1 is employed in this study. 1.5 Scope of the Research Based on availability of data of institutions and review of recent history of currency crises in emerging market economies, 15 economies are selected and the period of study is limited in 1996-2005. 15 economies are: Argentina, Brazil, Colombia, Czech, Ecuador, India, Indonesia, Korea, Malaysia, Philippines, Russia, Slovakia, South Africa, Thailand and Turkey. 1.6 Organization of the Research The first chapter of this study hereby presents introduction of the issue. The second chapter will look through theories of currency crisis. The third introduces some typical early warning systems (EWS) and empirical currency crisis models employed at IMF, Goldman Sachs and in a few academic studies. The fourth mentions methodology for designing a EWS model including variables of domestic credit growth and institutions. The fifth represents merits of the focused variables in the model and the sixth delivers policy implications and concludes. Page 6 of 52 Chapter 2 Theories of currency crises - A brief review of the literature In the literature of financial crises, there are banking crises, (sovereign) debt crisis and currency crises. Banking crises are recognized as the insolvency of the banking system that occurs with high ratio of non-performing loan to assets. Demirguc-Kunt and Detragiache (1997) considered one of event or combination of the following as banking crisis: (1) nonperforming assets/total assets ratio in the banking system exceeds 10%; (2) the cost of rescue at least 2% of GDP; (3) large scale nationalization of banks; and (4) extensive bank runs or other emergency measures executed by the government. Debt crisis is defined as a national government fails to meet a principal or interest payment on the due date (Reinhart and Rogoff, 2008). This study focuses on currency crises only. This chapter consists of 2 parts. Part 1 presents the identification of a currency crisis, part 2 reviews 4 generations of currency crisis models. What cause a currency crisis? It is an exciting question since the collapse to the Breton Wood system. Especially, the heavy costs of currency crisis in Mexico, Asia, Russia, Argentina ... provoke attention of several economists. 2.1 Identifying currency crises An abrupt drop in a country currency value is regarded as currency crisis. It is called 'crisis' because it bring about negative economic effects. They includes shrink in GDP, investment and job loss, banking and business failures, inflation. Currency crisis can be brought about by currency speculators or government action, or a mix of both. The ideal way to define a currency crisis is as Bussiere and Fratzscher (2002) that incorporate moves in exchange rate, interest rate and foreign reserves (initially set out by Girton and Roper, 1977). They identified a crisis as the exchange market pressure (EMP) of a specific country exceeds its mean by 2 standard deviations. EMP is constructed as a weighted average of the change of the real effective exchange rate (RER), the change in the real interest rate (r) and the change in foreign exchange reserves (res). Real values are considered to avoid different inflation rate across countries. Interest rate is involved in case the central bank defends the domestic currency by increasing its interest rate. Page 7 of 52 The EMPi,t for defining a currency crisis for each country i and period t in formula is as follows: _ EM~.~ - . ( RERi.t -. RERi.t-'i) (. _ , ) _ ( resi.r- resi,1-l mRER +mr li.r lu-1 mr~z .. The weights ffiRER, ffir RE/1. t"'"i. 1 . · ~ res.!.}_,• J and ffires are computed as the inverse of the variance of each variable for itself so as to give a larger weight to the variables with less volatility. Due to lack of data, most of the cases currency crisis is defined with changes in exchange rate and foreign reserves only like Kaminsky et al. ( 1998) (KLR) with a little bit difference in the threshold of number of standard deviations. KLR model recognized a crisis as EMP goes beyond its mean by 3 standard deviations. In another simple way, Frankel and Rose (1996) defined a currency crisis as a depreciation of the nominal exchange rate by at least 25% that also exceeds the previous year's depreciation by at least 10%. Thus, they did not consider speculative attacks failed by government intervention via selling foreign reserves as a currency crisis. The theories of currency crisis have developed over the time. It seems that after a series of currency crises occurred, a new-generation crisis model emerges. A brief review of currency crisis literature can trace out 4 generations of currency crisis model. 2.2 Four generations of currency crisis models The first generation crisis models The first generation crisis model is firstly presented by Krugman (1979). In a small open economy, government would defend the fixed exchange rate regime with limited foreign reserves. Perfect foresight private investors hold asset portfolio in two kinds of assets: domestic and foreign currency. In an attempt to maintain the fixed rate, government has to sell out reserves until it is exhausted. Government finances its budget deficit by printing money that increases money supply. Page 8 of 52 The model derives that as long as there is budget deficit and inflation, investors change the composition of their asset portfolio by increasing the proportion of foreign exchange, reducing the proportion of domestic currency. Government has to run down its reserves to retain the fixed rate on the way to finance its budget deficit. Exhaustion of reserves pushes government to abandon the pegging. Such expectation makes investors advance the date of their speculative attacks, the leading speculators sell domestic money even earlier and so on, reserves run out faster and currency crisis breaks out. The model seems to have highly simplified assumptions on two asset portfolio holding, the tools government uses to intervene in foreign exchange market, only selling reserves, perfect foresight speculators, the time of crisis is unclearly identified. Flood and Garber (1984) refined Krugman (1979) model by developing it into 2 models. The first one is a perfect-foresight, continuous-time model that relaxes two-asset portfolio to 4asset portfolio (included domestic and foreign bond) and adding domestic credit into the model. They found out the exact timing of the peg collapse, and timing has a positive relationship with the size of reserves and a negative one with the domestic credit growth rate. The first model also shows that currency crisis can emerge under arbitrary speculative behavior of investors but they assumed that this effect is zero for simplifying analysis. The second model is a discrete time, stochastic one (relax assumption of perfect foresight) that incorporate uncertainty to study the forward exchange rate of a peg regime as a response to reality that forward rate may exceed the fixed rate for long period of time. Using the concept the shadow exchange rate, the rate that would prevail after the speculative attack, the second model yields an endogenous probability distribution over the crisis time and produces a forward exchange rate that is greater than the fixed rate (capture the real world). The policy conflict in above-mentioned models is the financing fiscal deficit and retaining fixed exchange rate regime. Dooley (1997) proposed an insurance model, in which the policy conflict is the desire of a credit-constrained government to hold reserve assets as a form of self-insurance against shocks to national consumption and the government's desire to insure financial liabilities of residents. The first objective is pursued by accumulation of foreign reserves while the second objective depletes it. Once the domestic yield is greater relative to international returns, it generates a private gross capital inflow. Capital inflow increases to an extent that there is not enough foreign reserves to insure deposits, extra deposits have risk exposure. This gap will ignite a speculative attack to minimize loss that runs up to crisis. Page 9 of 52 Dooley model offers a capital inflow/currency crisis follow view, that not budget deficit, money supply or higher international interest rate is blamed for currency crisis. The first generation models explained well the crisis of Latin America countries in the 1980s that have macroeconomic fundamental problems such as fiscal deficit, hyperinflation, foreign loan, current account deficit, capital flight. The first generation models suggest that macroeconomic fundamentals are the causes of currency crises. Variables used in early warning systems could be budget deficit, money supply, domestic credit, current account deficit, international interest rates, capital inflow/outflow (capital control). In the early 1990s, there were several currency crises, such as the European Monetary System crisis of 1992-93, that could not be explained by the first generation models. Europe countries at that time had sound macroeconomic fundamentals, but currency crises still occurred. The currency crisis model then evolved to confront the new reality. The second generation came out. The second generation crisis models The second generation crisis models, initially developed by Obstfeld (1994, 1996): selffulfilling and contagious crises. The first generation models constrained government's tools in intervening foreign exchange market to selling limited reserves only. The second· generation models relax this point, let foreign reserves can be freely borrowed in the world capital market, subject only to the government's intertemporal budget constraint. In a setting of purposeful reaction by the government, self-fulfilling crisis is taken into account. Speculative anticipations depend on government responses, which subject to how price changes, that in turn are driven by expectations. This dynamic circle suggests a potential for crises that would not have occurred, but that do because the market players expect them to. They are self-fulfilling crises. Obstfeld (1994) raised a question: Why does the government like to abandon the fixed rate? He described 2 models in the paper to answer. It is because government debt denominated in domestic currency and unemployment problem. In one model, he mentioned the role of Page 10 of 52 nominal interest rate. Devaluation expectations feed into high nominal interest rate that pushes government further to give up the peg would have been viable under reverse private expectations. Maturity structure of the government's domestic obligations and the currency composition of the overall public debt would decide the effect of interest rate in devaluation. Large portion of debt burden denominated in domestic currency, higher nominal interest rate will lead to higher devaluation to lessen the government debt burden. Perfect foresighted speculators would try to get out of the domestic currency ahead of that devaluation. In another model, expectations feed into wages and competitiveness, raising unemployment. The country suffers from unemployment/competitiveness problem due to demand shock and/or pre-set nominal wage, would like to abandon the fixed rate. Negative expectation of government's willingness to tolerate unemployment can trigger a devaluation that would not have occurred under opposite. expectations. In contrast to the first generation models, the loss of reserves is not the factor triggering currency crisis. The models propose that a speculative attack can occur even with the absence of poor macroeconomic conditions in the pre-crisis time. Currency crisis can result from self-fulfilling attack in which speculative anticipations and herding behavior play a role. Once unemployment rate is on upward trend and government policy is to maintain a fixed exchange rate. Speculators can perceive that high political cost of the maintaining of the fixed exchange rate facing the future rising unemployment. They recognize the devaluation is likely. Even they don't know when, they start selling domestic currency now. Herding behavior sets in and full-scale speculative attack breaks out even before unemployment becomes a problem. Eichengreen et al. (1996) show that contagion takes its effect once the devaluation of a country's currency may reduce its trading partners' competitiveness enough to make their currencies subject to devaluation too. They pose hypothesis that there are 2 channels for contagion taking effect. Trade linkage between 2 countries can motivate one country to devalue its currency to increase its international competitiveness one the other country devalued previously. Based on the current and prospective international competitiveness of the countries concerned, speculators ignite attacks. The similar macroeconomic conditions across countries also are foundations for advancing speculative attacks. Using a panel of quarterly data for 20 industrial countries for the period 1959-1993 to test for contagious currency crises, they find evidence of contagion. Contagion appears to spread to countries which have close international trade linkages rather than to countries in similar macroeconomic conditions. Page 11 of52 Calvo (1995) suggest that the basic cause of a currency crisis may be investors' behavior. Risk averse investors invest in several countries. Financial diversification and lender's information have an interesting relationship. Investors with highly diversified portfolio have lower incentives to learn about individual countries than investors with few diversification opportunities. Diversification encourages ignorance and, in that context, rumors could result in massive capital flows from a country. So investment into or away from a country is highly sensitive to news in a world of highly diversified investors. Diversification magnifies herding behavior by making investors more sensitive to rumors. If the composition of portfolio is mainly short-term capital, the capital flight may be quick, causing an abrupt crisis. If self-fulfilling crises are a real possibility, what stimulates them? The answer is that anything could in principle be the driver. They would be expected unemployment, public debt, international competitiveness in trade, political factors ... This rationale gives a spacy room for empirical early warning system models in predicting crises. Second-generation models can explain the European Exchange Rate Mechanism (ERM) crisis in the 1990s. These crises didn't emerge by the poor macroeconomic fundamentals but by inconsistent policy and political events. In Europe, the crises occurred in Britain, Italy, France because of the inconsistent policy with their committed peg to the German mark. Retaining peg to German mark, they have to maintain high interest rate on local currency and face slow growth, gloomy export and increasing unemployment. Speculators such as Soros recognized the tradeoff government confronts and expected the government under political pressure will give up the peg. Their speculative attacks succeeded. In fact, behind the scene of claimed sound macroeconomic fundamentals, potential economic instability laying aside in Europe incites speculative attacks. Macroeconomic fundamentals actually still play their role to a certain extent in the second generation model of crisis. In 1997-1998, new reality of crisis emerged again that requires currency crisis model to continue to evolve to deal with new generation of crisis. The third generation crisis models The Asian crisis of 1997-98 led to the third generation models: twin crisis, a mix of banking and currency crisis. In fact, Velasco ( 1987) proposed models of interaction between banking problems and currency crisis. Credit boom, bad debt, government spending on bail out Page 12 of 52 (budget shrinks) and stop of capital inflow all lead the way to abandonment of fixed exchange rate regime. Velasco (1987) represented experiences in South America with these features. Their models received little attention until the Asian crisis in 1997 broke out. What Velasco did is to extend Krugman model to a situation where foreign assets pay interest, including the presence of banks to find out the dynamics of banking crisis and currency crisis. There is an asymmetry in the liquidity and riskiness of bank assets and liabilities. A bank usually guarantees the nominal value of the deposits it accepts while allocating the money to investments with a variable return. Normally, bank deposits are highly liquid, while bank investments are low liquid and long-term. It takes time and cost to liquidate bank investments. There is an assumption that all bank deposits are implicitly or explicitly guaranteed by the government. Domestic and foreign depositors/lenders believe in the government umbrella, still put money into the banking system in spite of banking operation loss. Banks play the Ponzi game until the problem become serious. Government steps in to help, depletes its budget and foreign reserves. Currency crisis of Krugman type eventually arrived here. Using monthly data of 20 countries for the period 1970-mid1995, Kaminsky & Reinhart (1999) also found that problems in the banking sector typically emerge before a currency crisis. The currency crisis then worsens the banking crisis, making a vicious spiral. Financial liberalization often precedes banking crises. The progression of these events suggests that crises occur as the economy starts to enter a recession, following a boom in economic activity that is fueled by credit, capital inflows, associated with an overvalued currency. Compared to first and second generation models, Asian crisis appears to be differently. Macroeconomic fundamentals are sound with· high GDP growth rates, low unemployment rate, low inflation, low budget deficits, manageable current account deficits, strong capital inflows and prevailed political stability. However, inside the bright picture, there are problems in the banking sector - bad loans from domestic borrowers and unhedged, shortterm borrowing from foreign banks. The bad loan accumulation is the consequence of over lending. Krugman (1998) described a moral hazard/asset bubble view. There was a boom-bust cycle in the asset markets preceding the Asian currency crisis. Prices of stock and land were soaring and plunging before the crisis. Besides, moral hazard involved as strong political relations between government and finance companies/banks/corporations (crony capitalism) suggested implicit guarantees from government for lenders and depositors. The lenders become much less prudent in lending to inefficient investment projects because of expectation on government bailout. Page 13 of52 Third generation model implies an additional set of variables related to financial liberalization and banking problem for early warning system. Name a few as: Real interest rate, lendingdeposit rate ratio, M2/reserves, bank deposit, non-performing loan. Recently, we faced the re-emergence of institutional economics (economics Nobel prize 2009 is an award for institutional economics) that pays more attention to the foundations for market functioning that shed new light on currency crises. The fourth generation crisis models Behind the scene of phenomena like government budget and current account deficits, hyperinflation, self-fulfilling attacks, herding behavior, excessive lending, deeper questions should be raised. What institutional factors set conditions for these pictures? In these models, institutional factors are incorporated and emphasized with a wide range: law framework, property right, enforcement of contract, financial regulations, bureaucratic quality, government stability, democracy and corruption ... Breuer (2004) coined these models as the fourth generation. This institutional focus has foundations on the theory of relationship between institutions and economic growth/crisis presented by Acemoglu et al. (2002), Rodrik et al. (2002), Fukuyama (1995), Sen (1999), Johnson et al. (2000) and asymmetric information problem in financial market by and Mishkin (1996, 2001) as typical ones among several other authors. A defmition of institutions is helpful here. What are institutions? By words ofDouglass North (1993) in his Nobel prize lecture: "Institutions are the humanly devised constraints that structure human interaction. They are made up of formal constraints (rules, laws, constitutions), informal constraints (norms of behavior, conventions, and self imposed codes of conduct), and their enforcement characteristics. Together they define the incentive structure of societies and specifically economies." Incentives and expectations play a vital role in the financial world that is infamous for uncertainty. Institutions form the foundations and facilitate a well-functioning currency and banking system. That's reason why the fourth generation models of currency crisis incorporate institutional variables. Page 14 of 52 Fukuyama (1995) proposed the role of trust in society that lowers administration cost, increases institutional reliability and promotes large and efficient organizations. Low trust society usually has corruption and trade with influences and tends to maintain small and inefficient organizations. Trust should promote economic development. It is vital for financial market whether investors have trust or loss of confidence in them. Sen (1999) presented concisely some of his best-known work on famines. They are usually occurred by a lack of purchasing power or entitlements, not by food shortage. He claimed that large-scale famines never happened in a democracy. They can only happen in authoritarian regimes lacking openness of information and transparency. His analysis inspired similar approach to the Asian crisis in 1997. Johnson et al. (2000) proved that the effectiveness of protection for minority shareholders explain the extent of declines in exchange rate depreciation and stock market better than standard macroeconomic measures do. They modelized the conflict of interest between insiders (managers) and outsiders (equity owners). Weaker corporate governance rules and a weaker legal system reduce the cost of stealing (expropriation) of managers. The manager compares the marginal cost and marginal benefit of stealing for their reaction. For a given rate of return, if the manager invests less their own money, they have more incentives to steal. However, if the manager has more shares in the firm, an increase in the return on investment persuades himto invest more into the project and, therefore, to steal less. On the other hand, if the manager owns more of the firm, but the return on investment reduces, then he steals more. The stealing of manager shrinks value of firm. Less value of the firm, less confidence of foreign and domestic investors stays in the stock market. Loss of confidence in the stock market triggers capital outflow or stop of capital inflow. The capital outflow affects foreign exchange market, ignites currency crisis. In order to study 27 emerging markets in the end of 1996 to January 1999, Johnson et al. employed data measure institutional variable such as: shareholder protection, credit right, accounting standards, enforceability of contracts Gudicial efficiency, corruption, rule of law, corporate governance); economic variable like: fiscal and monetary policy, current account and reserves. Running linear regression of these institutional and economic variables on exchange rate and then stock price, they found that the regression results support their theory. Lower quality of shareholder protection and enforceability of contract have high statistical significance and influence in explaining the depreciation of domestic currency and decrease in stock price in emerging markets. Page 15 of 52 Acemoglu et al. (2002) observed that countries pursuing poor macroeconomic policies also have weak institutions, including political institutions that do not constrain politicians, weak property rights for investors, widespread corruption, and a high degree of political instability. They proposed that macroeconomic policies are more likely to be symptoms of underlying institutional problems rather than the main causes of economic volatility, weak institutions can cause volatility through a number of macroeconomic and microeconomic channels. Mishkin ( 1996, 200 1) approached financial crises in the light of asymmetric information with the moral hazard problem. Emerging market economies such as Mexico, Ecuador, East Asian crisis countries and Russian are well-known for weak financial regulations and supervision. When financial liberalization facilitate international capital inflow and opportunities to take more risky lending, these weak regulatory/supervisory system could not limit the moral hazard problem created by the government safety net. Once government has signals offering bailouts to protect banks & corporations, excessive risk taking is one result, increasing the probability of financial crisis embracing banking crisis and currency crisis. Mishkin also proposed 12 areas of policy to prevent financial crisis: 1. Prudential supervision, 2. Accounting and disclosures requirements, 3. Legal and judicial systems, 4. Market based disciplines, 5. Entry of foreign banks, 6. Capital control, 7. Reduction of control of stateowned financial institutions, 8. Restrictions on foreign-dominated debts, 9. Elimination of too-big-too-fail in the corporate sectors, 10. Sequencing of the financial liberalization, 11. Monetary policy and price stability, 12. Exchange rate regimes and foreign exchange reserves. From this list, we can see some institutional factors that cause financial crisis. Rajan, R. G. and Zingales, L. (1998) looked through the Asian crisis, pointed out that relationship-based systems (that are inefficient and corrupt) tend to attract short-term external capital inflows that make them excessively prone to shocks. A relationship-based system distorts the price system and the signals it provides. As a result, it can misallocate capital. Majority of external capital inflow is typically from foreign investors that have little contractual rights or power in a relationship system. They understand the potential for misallocation and keep their claims short term for easy withdrawing. Due to the definition of institutions, they may include factors of law system, legal practices, financial regulations, politics, customs, culture. Thus the fourth generation crisis models spare large room for the choice of variables usable in early warning system for currency crises. The US crisis 2008: a new crisis generation or an old story? Page 16 of 52 The existing crisis in the US is in fact a banking crisis caused by excessive lending on subprime mortgages (Ellis, 2008). The sub-prime mortgages are cut into pieces in securitization process and the risk become opaque, then are sold out, spread in the US and over the world. Like the scenario is described in the third crisis generation (twin crisis), banking crisis come first, government implements giant bailouts of banks/corporations and then currency crisis follows. There are holes in financial regulations in the US financial system that promotes such excessive risk lending (no job-no problem housing loans). Thus, the fourth generation factors can also be used to explain the US crisis. Although FED's newly-issued treasury bonds (for bailouts) are supported by huge international reserves from China, the US dollar is being depreciated against other main currencies (EUR, GBP, AUD). So we can consider the US crisis is kind of third and fourth generation combination. Theories on the causes of currency crises set foundation for several early warning system and empirical currency crisis models coming out. The four generations of currency crisis models suggest what variables should be employed in empirical early warning system and currency crisis models. While the first and the third generation models point out the specific economic variable such as budget deficit, current account deficit, money supply, capital flow, bad debts as indicators of currency crisis, the second and the fourth generation give more room for choices ofvariables. It is because expectations can be based on a wide range of indicators and institutions involve a lot of factors related to laws, politics, culture. Page 17 of 52 Chapter 3 Typical early warning systems and empirical currency crisis models - A brief review of the literature The Mexican and Asian crises took the international community somewhat by surprise and since then raised the attention on methods that could forecast crises of highly vulnerable countries in the timely manner. Several early warning systems (EWS) empirical currency crisis models have been. designed and some of them are being used by IMF and private financial institutions like Goldman Sachs for policy and speculative purposes. The Table 1 hereunder summarizes the main features of typical EWSs, including EWSs used in IMF like Kaminsky et al. ( 1998), Berg and Pattillo (1999b), in Goldman Sach like GS-WATCH (Ades et al., 1998), and EWSs presented in other academic studies like Peltonen (2006), Shimpalee and Breuer (2006), Leblang and Satyanath (2008). 3.1 Signal approach Kaminsky et al. ( 1998) (KLR) proposed observation of 15 indicators that give warning signals prior to a crisis. KLR's crisis definition is previously mentioned in chapter 2. of this study (Theories of currency crisis). KLR selected 15 indicators based on prior theories and on the monthly data available. 15 variables are listed below: 1. Real exchange rate deviation 2. Banking crisis 3. Export 4. Stock prices 5. Growth rate of M2/ international reserves 6. Output 7. 'Excess' real M1 balances (Residual from regression of real M1 on real GDP, inflation, and a deterministic trend) 8. International reserves 9. M2 multiplier 10. Domestic credit/GDP 11. Real interest rate Page 18 of 52 12. Terms of trade 13. [Real interest differential 14. Imports 15. Bank deposits 16. Lending rate/deposit rate] An indicator gives out a signal whenever it moves beyond a specific threshold. Thresholds are defmed in relation to percentiles of the distribution· of observations of the indicator. An optimal threshold for a given predictor, such as export loss, might be 70, for example, that is uniform across countries, the corresponding country-specific thresholds would likely differ (for example 20% in a country, 30% in another). The performance of each indicator is considered in the following matrix: Table 3.1: Matrix of measuring performance of indicators Crisis No crisis (within 24 months) (within 24 months) Signal was issued A B No signal was issued c D Source: (Kaminsky et al., 1998) In this matrix, A represents the number of months in which the indicator issued a good signal, B is the number of months in which the indicator issued a bad signal or 'noise,' C is the number of months in which the indicator failed to issue a signal which would have been a good signal, and D is the number of months in which the indicator did not issue a signal that would· have been a bad signal. The optimal percentile threshold is the one that minimizes the bad signal to good signal ratio [(B/(B+D)]/[A/(A+C)]. Four indicators (Real interest differential, Imports, Bank deposits, Lending rate/deposit rate) that produce excessive noise are eliminated from the KLR model. As described by Berg and Pattillo (1999a), Kaminsky 1 later developed a single composite indicator of crisis that is computed as weighted sum of the indicators, where each indicator is weighted by the inverse of its bad signal/good signal ratio. Then a probability of crisis for each value of the composite index is calculated by the number of months having a given value of the index is followed by a crisis within 24 months. Page 19 of 52 Because of the shortcoming of signal approach in testing statistical significance of each indicator, most of the EWSs are probit/logit based models. 3.2 Probit/Logit approach Berg and Pattillo (1999a) modified and carried out out-of-sample test for the KLR model to predict Asian crisis 1997. Berg and Pattillo added 2 additional variables (Current account deficit/GDP ratio, level ofM2/Reserves) also replaced 5 developed countries in the sample by 8 emerging market countries. Then they transformed KLR's signal approach to probit based model with 05 variables only (Reserves growth rate, Export growth rate, Real exchange rate deviation, Current account deficit/GDP and M2/Reserves). Probit and modified KLR performed well in predicting Asian crisis 1997. However, probit model with 5 variables can test the statistical significant of individual indicators with ease while the KLR model (with 17 variables) can not do it. (Table 3.2) Berge and Pattillo (1999b) (BP model) presented a simple probit model over a panel of developing countries through 1995 to predict Asian crisis 1997. They found that 5 variables (Reserves growth rate, Export growth rate, Real exchange rate deviation, Current account deficit/GDP & Short-term debt/Reserves)-measured in percentile- performed well in forecasting the crisis 1997. They regarded the first 4 variables as first generation ones and short-term external debt/reserves as second generation one. Short-term external debt/Reserves ratio is used to measure vulnerability to panic, suggested by Radelet and Sachs (1998). Once foreign lenders become convinced that other lenders would not roll over their loan, there are not enough reserves to cover the mature loans. Panics tum into self-fulfilling. (Table 3.2) Goldman Sach's GS-WATCH model, designed by Ades et al. (1998), is the logit model employing 09 variables (Table 3.2) included 01 political risk indicator. Like BP model, their definition of crisis involves reserves loss and nominal exchange rate move, but they have specific thresholds for specific countries by using Self Exciting Threshold Autoregression technique (also used to identifY recession in business cycle literature). Different from BP model, GS-WATCH incorporates stock prices, real interest rate in G7 economies, contagion, credit (to private sector) growth and political risk - a fourth generation variable. For their purpose of private institutional investor, the predicting horizon is 3 months only. Their insample test proved their model worked well in predicting currency crisis in developing countries. (Table 3.2) Page 20 of 52